A Meeting of Giants

  Citigroup's plans to buy the card business of Sears, Roebuck and Co. turned heads in the card industry. What impact will the deal have on the beleaguered retailer and the largest bank card issuer?
  When the largest bank card issuer buys the card portfolios of the second-largest retail issuer, it's bound to cause a stir. Such is the case with the July announcement by card-industry juggernaut Citigroup Inc. that it is acquiring Sears, Roebuck and Co.'s private-label and MasterCard portfolios.
  For Citi, the acquisition of Sears' $12.4 billion MasterCard portfolio further solidifies its position as the top bank card issuer. And the purchase of Sears' $18.4 billion private-label portfolio, coupled with its recent acquisition of Home Depot's retail portfolio, elevates it to the number-one private-label issuer as well. Citi is purchasing the portfolios for a total of $32 billion, a 10% premium, with the deal expected to be completed by year-end.
  Hoffman Estates, Ill.-based Sears will receive at closing net pre-tax cash proceeds of about $6 billion, which represents a $3 billion premium on receivables and about $3 billion on Sears' net invested capital. Citigroup also will support Sears' 0% financing program at no cost to Sears, representing an additional $200 million in expected savings.
  In return, Citi is acquiring a highly profitable card business. Sears' card portfolios have shored up the retailer's bottom line at a time when its merchandise sales are on the decline. The card business typically accounts for well over half of Sears' earnings. Indeed, the major credit-rating agencies downgraded Sears' corporate debt after the announcement of the deal.
  Sears put its card business on sale so it could focus on rebuilding its core retail and related services. Over the past few years, Sears has lost ground to other retailers, including Target and Wal-Mart. Sears plans to use the proceeds of the card business sale to pay off corporate debt.
  The credit division generated more than $1.5 billion in income in 2002. In contrast, the retail and related services delivered more than $31 billion in revenue, but only $1.2 billion in operating income.
  For the second quarter, operating income for Sears' credit division rose to $355 million, up 46% from $243 million in the year-ago quarter. The earnings included a $93 million gain on the sale of $4.5 billion in previously charged-off accounts. The division reported revenues of $1.35 billion, down 3% from $1.39 billion for the same three-month period last year.
  But Citi also faces challenges as it moves to absorb the Sears portfolios. Although the card business is a top revenue generator for Sears, bad-debt losses are on the rise. At an analysts conference in February, Sears Chairman and Chief Executive Alan J. Lacy revealed that about 15% of Sears $12 billion in Gold MasterCard receivables weren't meeting expectations, due in part to a direct-mail campaign to add non-Sears cardholders. Accounts acquired during the campaign resulted in lower credit-quality accounts with higher chargeoff rates.
  To correct the problem, Sears last year reduced MasterCard mailings, cut back on convenience checks and balance-transfer marketing, and brought in outside experts to review its business processes. It also tightened underwriting when renewing MasterCard accounts and reducing credit lines on high-risk and inactive accounts, and beefed up collections.
  Nevertheless, credit quality took a beating. Sears increased its loan-loss reserves by $189 million during 2002's third quarter. Not long afterward, Lacy fired card chief Kevin Keleghan, bluntly saying that he had lost confidence in Keleghan's "personal credibility." Keleghan is contesting the firing in a lawsuit against Lacy and Sears in Lake County, Ill.
  In 2003's second quarter, Sears reported a chargeoff rate of 6.48% of receivables for the Gold MasterCard portfolio and of 6.89% for the private-label card.
  And the amount of charged-off debt will almost certainly rise. One of the first moves Citi is expected to make is to replace Sears' practice of charging off debt at 240 days past due with the 180-day chargeoff policy required by the Federal Financial Institutions Examination Council. That will result in an upturn in chargeoffs as accounts are written off earlier than in the past.
  Despite the recent problems with credit quality in the Sears MasterCard portfolio, observers say the acquisition will prove profitable for Citi.
  Profit Generator
  "It's fair to expect the overall performance of the portfolio to generate fairly attractive returns," says John C. Grund, principal at Linthicum, Md.-based First Annapolis Consulting. "I would expect this to be a consistent generator of profits" both for Citi, and for Sears as the recipient of marketing revenue.
  As part of the deal, Sears and Citigroup have entered into a long-term marketing and servicing alliance for an initial term of 10 years. Sears expects to receive $200 million in annual performance payments from Citi based on generation of new accounts and credit sales. "Sears has a long track record of being able to generate accounts in-store," Grund says.
  Sears adds an average of between four million and five million new accounts per year, with three million or more added through the in-store channel.
  Citi's announcement of the acquisition received a warm welcome from the three major ratings agencies, which affirmed Citi's long-term and short-term ratings. Fitch Ratings Inc. says the acquisition will "strengthen Citigroup's credit card franchise, further cementing its bank card market share and providing critical volume to its private-label business."
  Moody's Investors Service agreed, saying that the acquisition "enhances Citigroup's market-leading bank card franchise and provides an opportunity to establish a leading position in the private-label card market."
  The value of Citi gaining access to Sears' 59 million customers can't be underestimated, observers say. Sixty percent of U.S. households are Sears customers. And Hispanic customers, one of the fastest growing and potentially lucrative segments, account for 18% of that group. That offers new cross-selling opportunities for Citi.
  What's more, in 2002, 44 cents of every dollar spent at Sears was put on a Sears' credit product.
  On the private-label side, 16 million of 33 million accounts are active. The average active account age is 10-plus years, and the average credit line is $2,500, according to Sears. The average account balance is $1,200. The cardholders have an average household income of $51,000.
  In comparison, the Sears Gold MasterCard is directed to higher credit-quality Sears customers, those with an average Fair Isaac Corp. score per active account of 720. Of 27 million Gold MasterCard accounts, 9 million are active.
  The average credit line for Gold MasterCard accounts is $9,200, and the average household balance, $1,555. Household income averaged $56,000. Thirty percent of purchases on the card are made at Sears.
  But the agencies also had some concerns. Standard & Poors Inc. says that with the acquisition of the Sears portfolios, a larger percentage of Citi's business will be in credit cards. "To us, that's not a good thing," says Tanya Azarchs, S&P manager of financial services ratings. "We don't like a concentration of any kind."
  Selling Socks
  Sears' private-label cards are doing okay for a proprietary card portfolio but "that business in general has elevated loss rates compared to more plain-vanilla MasterCards," Azarchs says. "Even if it's a good private-label business, it will be more risky than a plain-vanilla credit card portfolio."
  "Obviously, the goal of the issuer of those cards, which has been Sears, was more to sell socks than it is to make money on credit cards," she adds.
  Furthermore, the fortunes of the newly acquired portfolios will be tied to the ability of Sears to retain and improve its position as a major retailer, says Eileen Fahey, an analyst with Fitch Ratings.
  S&P analyst Gerald Hirschberg noted that Sears' retailing business "has a very challenging future," as the retailer tries to compete with discount chains that have come to dominate the market.
  Nevertheless, the reason Citi is paying what some observers considered a high premium for the portfolios is that "the Sears customer base is very important, and Sears will continue to originate customers," Fahey says. "Citigroup was very comfortable with Sears management."
  The close ties between a retailer and its private-label portfolio are acknowledged by Bill Johnson, executive vice president for the retail sector of Citigroup's Citicards unit. "There's always a connection between the credit card portfolio of a particular merchant and their branded card," he says.
  But Citigroup brings expertise that "will enable us to continue to have the card perform despite the cycles Sears may have from time to time," he says. "Hopefully, some of our expertise in managing the card business may in fact help them on the retail side."
  Adverse Selection
  And while the Sears' portfolios are plagued by bad debt, Citi's pre-eminent collections and credit-risk groups will result in an "incredible improvement" in credit quality, says Stan A. Myers, managing director at Card Analytics Consulting Inc.
  Adds Fitch's Fahey: "We certainly expect non-performing (loans) to increase when Citi adds this portfolio. But we think over time it will improve because (Citi's) risk-management practices will improve the performance."
  Fahey notes that Sears used less-stringent underwriting criteria for the bank card portfolio, resulting in adverse selection. "Citigroup thinks they'll be able to avoid (adverse selection) in the future," she says.
  Myers says he wasn't surprised that Sears experienced problems with its MasterCard portfolio.
  "I sat through a conference ... a year ago at which Sears presented their portfolio, their strategy and I had a strong sense then that 'boy, I wonder if they really know what they're doing,'" he says.
  Sears has great expertise in managing a private-label card portfolio, Myers says. But the retailer ventured into dangerous territory when it began flipping its private-label card holders to the Sears Gold MasterCard, he says.
  Sears launched its MasterCard in 2000 in an effort to keep cardholders who wanted more utility. The retailer converted millions of inactive or low-volume cardholders, and it also pumped out solicitations to non-Sears-cardholders. But a good number of those new cardholders were poor credit risks.
  "It's not a simple deal," to operate a bank card portfolio, Myers says. "The risk one takes on is incredible."
  He notes there are several key differences between a private-label card and a bank card portfolio. For bank cards, "the credit lines are higher, the strategies are different," Myers says. "You've got convenience checks, you have different pricing strategies, you have promotions for balance-transfer offers that have to go out."
  Know Your Customer
  That means the issuer has to "be very, very sharp with respect to account segmentation ... You have to really understand your customer a heck of a lot better," he says.
  Fahey agrees. "The fundamental Sears customer is a good customer," she says. "When Sears expanded beyond that is where they ran into problems."
  But Citigroup is well-positioned to turn the Sears MasterCard portfolio around, Myers says, noting that Citi is "among the best in class" when it comes to risk management and collections.
  Citi also will be able to bring economies of scale to the Sears portfolios, resulting in operational expenses "significantly lower" than Sears has, Myers says.
  Once the deal is completed, there should be no major changes for Sears cardholders, Johnson says.
  "We plan to run the business pretty much as it's being run today, only taking advantage of our skills and value adds ... that could improve on its performance," he says.
  And while the loss rates on the Sears portfolios are high, they should not hurt the overall credit quality of Citi's card business, Johnson says.
  For now, Citi plans to integrate the 8,300 employees and the facilities of Sears' card operation into its own card business.
  "Our primary aim is to maintain the customer service and relationship with the cardholders and not interrupt that in any shape, form or fashion," Johnson says.
  That means there will be close ties between Citigroup and Sears. "We'll work with Sears as a partner here to insure whatever we do will improve the experience (of the cardholder)," Johnson says.